How to Invest in Startups

06. Nov, 2015 No comments Author:

Investing in a startup has unlimited potential for profit, but there’s much more that could go wrong.

Go back to the beginning of Wall Street giants such as Microsoft Corp. (ticker: MSFT) and Alphabet (GOOG, GOOGL), and you are sure to find a startup phase when founders, friends, family and a handful of lucky outsiders acquired shares for next to nothing. Fortunes have been won this way.

Wouldn’t it be great if ordinary investors could get in on the action?

These days it’s far easier than it used to be, thanks to firms like MicroVentureMarketplace, Crowdability, AngelFire Ventures and others that study startup offerings and open the doors to outsiders with as little as $5,000 to invest, or sometimes even less. You can shop the list of startups online.

MicroVenture founder and CEO Bill Clark says that when his firm was launched in 2009, most startups sought local investors. “Angel investing was really just regional,” he says. “It was very rare that you would invest in areas outside your network, which was really your state, and maybe just your city.”

Now investors anywhere can have access. And on Oct. 30, the Securities and Exchange Commission voted to loosen rules for processes like crowdfunding so that you don’t have to be a well-to-do “accredited investor” to place your bets.

investing in a startup

But is this kind of investing a good idea? The chance at enormous gains comes with a very real risk of being wiped out.

“The ideal investor is somebody who understands startups or understands small business, knows that they are risky and knows there is an opportunity for a high rate of return if they diversify and make several investments,” Clark says.

“But if you can’t make the investment and then pretend that you don’t even have that money, and say that money is gone … then you should not be doing it.”

MicroVenture has raised more than $80 million for about 140 young companies. The firm gets a 5 percent commission from the startup, a 5 percent commission from investors and 10 percent of any profit investors realize. His typical investor puts $10,000 to $15,000 into each deal, tying money up for 18 months to seven years, he says. Citing regulatory reasons, Clark won’t give examples of how much his investors have earned.

Visions of startups often involve tech firms like Hewlett-Packard (HP) getting launched in a garage, but you might find infant manufacturing firms, importers and service firms as well. The fact is that most companies start small.

In many cases, the founders invest their own money, incorporate and then authorize creation of a set number of shares. Some of those are sold to friends and family, often at $1 each. Over a few years, more shares are sold to a widening circle of outsiders, often including venture capital firms and other professionals. If all goes well, the company eventually goes public, allowing its shares to be traded on a stock exchange, or it is merged or acquired by another company. Early investors have sometimes turned every dollar into $100, sometimes much more. Just ask Bill Gates or Mark Zuckerberg.

Of course, in many cases it doesn’t work out this way.

“Investing in startups can be tricky business,” says Michelle Seiler-Tucker, founder of Capital Business Solutions, a business brokerage firm in New Orleans. “If you pick the right business, you may end up a millionaire, or even a billionaire. But if not, you stand to lose everything you invest. Startups have a 90 percent failure rate, which is why they are such risky investments.”

Investing in a startup can be tricky business

Because of this, most startup opportunities are limited to “accredited” investors – people with six-figure incomes or at least $1 million in liquid assets, which does not include the home. This used to filter out most small investors, but now many middle-class folks can qualify, even people whose experience may be limited to picking a handful of mutual funds. The new SEC rules open the doors even wider.

But although investing is getting easier all the time, making good investing choices is still extremely difficult, says Mark Stansbury, an attorney in Columbus, Ohio, who specializes in structuring startups.

“In very early-stage investments, the due-diligence process is typically very casual – and the company has little information to uncover anyway, since these are brand new operations,” he says. “Disclosures are often inadequate by later-stage standards.”

Among the perils: The product may not work or the service many never catch on. A patent application may be denied. A competitor may come up with something better. Even a perfectly sound idea can fail because the firm can’t raise enough money, can’t surmount a regulatory obstacle or doesn’t have good management. And even if the company succeeds, the value of the initial shares may be diluted when more shares are sold down the line.

Finally, early investors often are stuck with their shares for years, because until the firm goes public or gets a buyout offer, there is no easy way to sell.

Most experts say the typical financial advisor – someone who would help you save for retirement and college costs – is not equipped to evaluate startups. Companies make startup investing easy vet the deals they offer, but there is little data to show how well they do it.

So, as a rule, only invest an amount you are willing to lose, especially if you’re not already adept at picking and choosing stocks.

“I’d limit the amount of an investment to 2 percent to 3 percent of portfolio value,” says Mike Chadwick, owner of Chadwick Financial Advisors in Unionville, Connecticut. Most experts say the entire high-risk portion of the portfolio, regardless of how many individual investments it has, should not exceed 10 percent to 20 percent of one’s holdings.

Source: money.usanews.com, text by Jeff Brown

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